The outperformance of smaller companies relative to the FTSE 100 (and by extension, the outperformance of active UK funds versus the FTSE All Share) might be coming to an end, according to JPM’s Alex Dryden, with a possible floor to commodity prices and sterling weakness potentially sparking this change in trend.
Active managers in the IA UK All Companies sector (taken on average) have had a good run of performance relative to the ‘average’ passive over recent years thanks to a variety of factors within the UK equity market.
According to FE Analytics, the ‘average’ active fund in the IA UK All Companies sector has beaten the FTSE All Share – which is the most commonly used benchmark in the peer group – by close to 15 percentage points over the past five years with a return of 44.61 per cent.
Performance of UK active funds versus the index over 5yrs
Source: FE Analytics
These figures do include survivorship bias, however, so we have included the performance of the IA UK All Companies sector as a whole – which includes closed or merged funds, as well as the peer group’s numerous trackers which have largely dragged down the overall returns – as well. However, that too has outperformed by a comfortable margin against the index.
As the graph above shows, the majority of active fund outperformance has come more recently. Indeed, FE data shows that some 75 per cent of active funds in the peer group managed to beat the FTSE All Share’s gains of 0.98 per cent in 2015.
One of the major reasons for this trend has been the stark underperformance of some of the largest companies in the UK (such as mining and energy) while, at the same time, smaller companies have delivered stellar gains as (by being more domestically focused) they have benefitted from an improving economic backdrop.
As such, by being underweight FTSE 100 stocks (which is a relatively easy task given they make up 80 per cent of the wider UK equity market) and taking bigger bets further down the market-cap spectrum, many active managers in the UK space have massively benefitted.
Of course, many would argue active managers should be lauded for making a correct ‘active’ decision, however Dryden – global market strategist at JP Morgan Asset Management – says investors should be aware of how closely correlated most active funds’ fortunes are to the relative performance of smaller companies versus the FTSE 100.
“Essentially, for the last six or so years, the consensus play within the UK active fund space has been to be underweight underperforming sectors such as commodities and energy and use that to be heavily overweight smaller companies,” Dryden said.
Performance of indices over 5yrs
Source: FE Analytics
“I would say these have got to fairly strained positions though, with the top decile of funds in the IA UK All Companies sector over five years now with a 71 per cent weighting to mid and small-caps.”
“Given most of them are benchmarked against the FTSE All Share which only has a 20 per cent weighting to mid and small-caps, you can see just how far active managers have had to stray away from the index to generate their outperformance.”
Though looking purely at averages can, of course, be misleading – FE data shows just how correlated active UK fund outperformance has been to the relative return of smaller companies against larger ones.
For example, the graph below shows the performance of the FTSE 250 index and the ‘average’ active fund in the IA UK All Companies sector relative to the FTSE 100 over the past decade. While the movements have been smaller both on the upside and downside, it illustrates how much active funds’ total returns have been dependent on the FTSE 250.
Relative performance of funds and indices over 10yrs
Source: FE Analytics
Indeed, when you look at calendar year performance, the only years that the IA UK All Companies sector (taken as a whole) has failed to beat the FTSE All Share has been in periods when large-caps have outperformed versus mid-caps – 2007, 2008 and 2011.
It must be noted, though, that active managers are paid to make off-benchmark decisions and making bigger allocations further down the FTSE All Share index is certainly one of those. Also, there is the consensual view that smaller companies outperform their larger rivals over the longer term due to the fact they are usually less mature and therefore offer higher levels of growth.
However, there have been prolonged periods in the past when large-caps have been the best performing area of the UK market and this, in turn, has had a profound effect on the ‘average’ active fund.
One of the best examples was during the 1990s, when the FTSE 100 index outperformed the FTSE 250 by 20 percentage points thanks to its gains of 293.33 per cent. This outperformance was largely due to the bubble in tech stocks, which as we know, subsequently burst.
However, as the graph shows, that decade-long period saw the IA UK All Companies sector (which was almost entirely made up of active funds at the time) underperform the FTSE All Share by some 50 percentage points.
Performance of sector and indices in the 1990s
Source: FE Analytics
There are also tentative signs that the major trend that has dominated UK equities over recent years, from a fund perspective, is starting to reverse.
Though – as many of you correctly pointed out – two and a half months is a very short period of time to judge fund performance, a recent FE Trustnet article highlighted that just 17 per cent of active portfolios in the IA UK All Companies sector were underperforming the FTSE All Share so far in 2016.
This has largely been because the FTSE 250 has yet to recover from the tumultuous first few weeks of the year, while the FTSE 100 has been powered forward by a major relief rally in the likes of mining and energy stocks as well as banks.
Some, such as Psigma’s Rory McPherson, have sold their passive exposure due to the already stark outperformance of large-caps so far this year.
“We’ve actually completely sold our passive allocation. The valuation difference between mid and mega-caps has now narrowed quite a lot as the likes of energy and mining companies have bounced ridiculously and we think this has now been overdone,” McPherson said.
However, Dryden says there are a couple of factors which could lead to larger companies outperforming mid and small-caps from here and therefore, by extension, put increased pressure on active UK managers.
“It’s still very early days so I would caution against making any large asset allocation changes, but there are signs that the tide is beginning to turn and these relate to the performance of commodity and energy companies and sterling weakness.”
“If we do continue to see signs of stabilisation and a floor underneath energy and metal prices, given these areas make a big proportion of the large-cap space but only a small proportion of the smaller companies space, that would therefore buoy large caps and be a very interesting story.”
“This trend has only just begun, of course, but if it persists then it is likely we will see a big reversal in the IA UK All Companies sector performance tables.”
He points out, however, that this trend isn’t just limited to sector performances as sterling – which has weakened considerably compared to other major currencies in 2016 so far – could also play a significant part.
Relative performance of currencies in 2016
Source: FE Analytics
“The pound has been weakening due to the uncertainty surrounding Brexit, but this is a benefit to large-caps with internationally sourced revenues,” he explained.
“Most large-caps have been competing with sterling strength which has been a headwind, but its weakness will help their quarterly earnings and give them a boost relative to many smaller companies. This is because while 50 per cent of revenues within small and mid-caps are sourced internationally, that figure stands at 75 per cent within the FTSE 100.”
“It’s a very interesting story and while it is still very early days, let’s see what happens over the next 12 months.”
